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Weakening Euro highlights currency risk

February 19, 2015

The recent decline of the euro relative to the US dollar has been widely broadcast, with the exchange rate reaching levels it hasn’t seen in nine years. Many investors are observing the impact of such a sharp currency devaluation on their international portfolios, serving as a reminder of the presence of currency risk in global investing.

Analysts point to growing concerns about the Eurozone’s economy as the primary reason behind the depreciating euro. Hopes for a Eurozone economic recovery abounded in 2013, and the euro appreciated against the dollar. But as 2014 unfolded and Eurozone economic data consistently disappointed, these hopes waned. Meanwhile, the US economy continued to strengthen on a relative basis, further accelerating the euro’s slide.

The impact of the tumbling euro on global portfolio returns sheds light on the presence of currency risk. Currency risk is defined as the potential risk of loss from fluctuating exchange rates when an investor holds foreign securities. For U.S. investors, any potential gains or losses are realized when the proceeds from an investment are converted from the foreign currency into US dollars.

In volatile currency markets the impact of currency risk can be significant. As illustrated below, when FTSE All-World Index returns are measured in different currencies, the results vary considerably as currency returns fluctuate.

Source: FTSE as of December 31, 2014. Past performance is no guarantee of future results.

Perhaps the best approach to interpreting this chart is to consider the perspective of each investor. As the euro’s dramatic slide began in 2014, the US investor holding a global portfolio was at a disadvantage, as foreign-denominated securities depreciated relative to the investor’s home currency, the US dollar. Conversely, the European investor whose portfolio included US dollar-denominated securities would have benefitted from the strength of the dollar. Reflecting this dynamic, the FTSE All-World Index in US dollars only returned 4.8%, relative to 19.3% when measured in euros.

The reverse is true in a weakening US dollar environment. When the euro was appreciating relative to the US dollar in 2013, the European investor who chose to invest internationally was at a disadvantage. For this time period the FTSE-All World Index returned 23.3% in US dollars, compared with 18.0% when measured in euros.

Such data fluctuations underscore the importance of understanding currency exposure and its potential impact on investment returns. As the investing landscape has evolved to include markets around the globe, currency risk has become an increasingly important consideration.

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